Some Real Estate Facts To Mull Over

Robert Shiller, by tracking the US home prices data from 1890 concluded that in the longer run, property prices grew at an annualised return of around 3%, just keeping pace with inflation.Housing price rises could not outstrip inflation in the long term because, except for land restricted sites, house prices would tend toward building costs plus normal economic profit.

I have no such data for India.But here is what I can attest to:an ancestral house acquired 120 years ago for 6000 Rupees is now valued at 1.2 crores-an annualized return of about 6%.I think this is close to the long term inflation rate in India.

(2)Is home ownership all that it is touted to be?

In a poorer country like Bangladesh, 90% of the houses are owner occupied. Whereas in a richer country like Switzerland, only 33% of the houses are owner occupied.

Europeans are more comfortable with renting compared to Anglo Saxons and we Indians need to decide whose model we choose to follow.Read what Niall Ferguson has to say about property ownership.

Niall Ferguson On The American Dream:

Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.

Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.

To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.

There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.

There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.

The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.

So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

Remember that in the not so distant past real estate was the sole preserve of those who could seize it and hold it.Even today real estate needs more resources to own.Be sure you have developed the means to deal with its risks before investing in it.

(3)House price to (annual) rent ratio:

By international standards if the house price to (annual) rent ratio is above 20, then the cost of owning is considered higher than cost of renting.The generally accepted range is around 15. If you live in a metro city in India you will be doing very well if you are getting a 5% return.A 2% return is more common.And if you are uncomfortable with taking the risk of litigating with tenants you will earn nothing as rent.The majority of home owners in India are holding out expecting capital appreciation.Hence in the real estate market many a times the prices do not come down even during slowdowns but markets simply become illiquid. No transaction happens but still the price on paper remains high.

(4)Annual income and home prices:

Internationally it is held that the value of the property a person is planning to buy on a loan should not be more than 3 years of their annual income.However this is what the GOI thinks:https://wealthymatters.com/2012/07/16/affordable-housing-defined/ .As a result many of us are likely to be house rich and have fewer liquid savings and investments.This is likely to lead to an overall lowering in out standard of living and force us to miss out on other wealth building opportunities.

(4)EMI to income ratio:

A general rule of thumb is that your home loan EMI as a part of your income (debt to income ratio) should not exceed 35% to 40% (maximum). Anything beyond this may put a huge strain on you especially in a rising interest rate scenario or any other contingency in life.In fact this is something to think about very seriously.Mortgages are long term contracts and jobs and incomes can vanish really fast.It is very easy projecting out our current strong financial situation out to infinity.Don’t omit reading Priya’s Story.Always keep aside a few months worth of EMIs to help you cushion any fluctuations in income.Do buy mortgage insurance and as a measure of ample caution try to not opt for more than one loan at a time.Remember that bank officers are incentivised to extend loans.So be sure to think before opting for a tempting loan.The grass always looks better on the other side.Its nice being a home owner but a loan is not always the best way to fund your purchase.It’s OK to rent.If you can’t take the risk don’t try to ride the property tiger and try to realize capital gains.Good years and perpetual capital appreciation are not guaranteed even in India.

11 Responses to Some Real Estate Facts To Mull Over

It will be interesting to see what happens to home prices in the future. Do you think it will ever outpace inflation in the long run? As more and more people are squeezed into cities, this long term demand increase might cause some sustainable price increases.

Another thing I have been wondering about is the variation in home price increases depending on location. In our last long conversation, I was quite surprised to hear about the high Indian home prices in your specific location, so it might be that the long term price trend in some good areas (such as yours) consistently outpace inflation in the long run.

There is also a lot of talk about whether Norway is inflating a housing bubble or not. Prices have been rising at roughly 8% over at least the past two decades (inflation is only about 2%). But most people think that this is OK since houses are bought to live in (not for purposes of speculation like the Americans do it) and Norway can therefore not end up with an over-supply of houses. Norway is also a very attractive destination for skilled immigrants who increase the home demand. Personally, I’m still trying to make up my mind on whether we are in a bubble or not…

From an investment point of view, owning a home in Norway is just a little too attractive at the moment. You can get a 90% loan quite easily, the interest rate is about 3.6% and you get 25% of the interest you pay back as a tax break. This implies that I pay about 0.7% interest in real terms while my home increases at about 6% in real terms. As a homeowner, I will definitely not complain too loudly about this, but I do think that it is a little bit too good to be true and can therefore lead to mass irresponsible behavior (a real bubble).

I think Schiller has the idea right.House prices will not rise over the inflation rate in the long run so long as there is no restriction on the amount of available land.Of course, long run might mean a few generations, not one lifetime.A house or shelter can’t cost more than the materials and labour to build it or its replica and this varies directly with inflation.But talk of homes and work on peoples’ hopes, aspirations and dreams and talk of how people became wealthy because of investing in their homes and appeal to greed and create a sense of scarcity and the sky is the limit for home prices.

Urbanization will lead to high prices in select pockets where the old money lives and where new money feels the need to purchase real estate to show they have arrived.Also there will be areas where the rich or people with good disposable incomes congregate. Otherwise my guess would be that cities in the developing world might spread outwards as more people acquire personal automobiles and public transport increases.Also there might be the development of self contained gated colonies and barrack towns in the outskirts.

About my area, here is what I observe:People moving in are new money.Obviously this is a status thing. And as long a India continues minting millionaires and billionaires this trend will continue.The people who buy here are those who can’t afford to go to the more expensive/exclusive areas. Second Mumbai is built on 7 islands and land reclaimed from the sea.Worli is one of these islands.So in a way land is scarce.However there are now developments on the mainland and road and rail connectivity to those areas too.Thirdly,people who can afford to do so, prefer to pay premiums for sea views and fresh sea breeze.This makes sense since Mumbai has few public gardens and has a lot of air pollution.The air circulation on the western side facing the Arabian sea is better than the circulation on the eastern side which faces creeks,so areas on the western coast are more expensive than that on the eastern-side.

As long as our governments keep depreciating our currencies real estate prices will keep increasing.If the majority of the population are home owners,every body will feel happy because the ‘wealth effect’ will make every one feel they are doing well.This makes governments popular.Also the construction industry and the real estate sector employs lots of people so governments find it necessary to pump prime this sector of the economy to keep employment figures up.
Thirdly governments earn taxes and fees from real estate transactions.This is another perverse incentive. Governments will do their damnest to keep the real estate sector growing.

Once upon a time real estate meant the king’s estate.Land belonged to those who chose to seize and hold it.Other people had various claims to land and its produce depending on their estate.Real estate was not so financialized.Real estate was not easily transferred for monetary consideration as is done today.Loans from banks were unheard of and low down payments is a recent development.If the down payment requirements were higher would /could you have bought your house early in your career?Would it have made sense?Would banks have had the opportunity to lend for as long a term?Would they not have earned less?

Here is something else to think about:What part of your house do you own and what part does the bank own.And in today’s scenario does your bank still own it or has the bank sold securities to pass off the risk.Does your bank now know who owns what part of your house ?Does any body?Multiply the situation many million times over across the world and you know the situation as it exists today.

A house/real estate might be a real tangible asset as a real gold coin in your hand.A mortgage is a financial/paper asset or liability depending on whether it is the bank or you talking.Mortgage backed securities are financial/paper assets and paper assets transfer purchasing power from one party to another.And time will tell who was wise or otherwise when dealing with paper assets.

Booms might go on forever but busts follow inevitably.From history I know that Bombay was built during booms and busts happened inevitably.So while I won’t say a bust is round the corner I think a bust is inevitable but I have no clue to its timing.The only sensible suggestion I have on real estate matters is buy what you need for your real needs and go easy on the extras.Italian marble and American design are not the be all and end all of life.Don’t buy with an intention to speculate unless you are very well off and having a chunk of your money stuck or lost in real-estate will not bother you.

Thanks for the detailed reply. There certainly are a very wide range of factors to consider when talking about house prices, but lately, I think, speculative bubbles have had by far the greatest influence worldwide. Governments and speculators are really causing a lot of damage in this way.

As you said, governments have a wide range of perverse incentives to drive artificial housing booms through low interest rates combined with inflation and large tax breaks on loan interest. The existence of such blatantly obvious moral hazards is a clear sign of a totally broken system.

Such an artificial housing boom leads to another great moral hazard: the fact that it becomes a lot more profitable to speculate than to produce. Taking out a cheap home loan in the buildup phase of one of today’s many housing bubbles is an absolutely brilliant way to use leverage and make incredible amounts of money through speculation. The fact that one can get very rich without rendering any useful goods or services to society is another sign of a totally broken system.

As I see it, our totally unbacked fiat currencies (and the godlike power they bestow upon lowly politicians and central bankers) are the fundamental root cause behind all of these gross injustices and will need to be overhauled pretty soon if the global economy is to avoid some kind of major catastrophe. However, all the pigs feeding at the trough of unearned wealth will make such an overhaul very difficult indeed.

Schalk my opinion is that we are living through an unraveling of the international financial system.Just how prolonged the phase will be and just how people cope are the only unknowns.
We will have a new international currency.I don’t know which one but it will be of a country with widespread trade and whose monetary prudence and fair play is appreciated world over.
Today every country is willy nilly depreciating its currency to maintain the status quo or improve its position in the world economic order.
What continues to interest me is George Soros’ interest in gold http://www.businessinsider.com/soros-gold-action-speaks-louder-than-trumpeted-bubble-words-2012-8
He has called currency movements correctly in the past.

True that. That old Chinese curse “may you live in interesting times” again comes to mind here. I really have no idea what to expect (except for unprecedented change of course) and only some vague ideas of how to position for these “interesting times” that lie ahead.

However, over the past week my precious metals hedge seems to show some positive signs. Silver is up about 10% with gold not far behind. George Soros and the like seem to be on the right track and could help start the massive shift in public opinion that unbacked fiat paper currencies are a fundamentally flawed idea and any system based on this concept will be inherently unsustainable (simply because of human nature).

George Soros draws blood big time.I doubt if he sees gold in such simplistic terms we do.He makes money by taking calls on the right valuation of currencies.At least that’s my understanding of his ‘ultimate bubble’comment.

Not that I can cite out of hand.And I am not certain that we can use that data without some adjustments as we had land ceiling acts till recently.But I will look for it and/or try to compile some data by polling friends and relations.